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U.S. Recessionary Gap

The U.S. economy currently is operating at less than the full-employment level of GDP. Interpret and illustrate this equilibrium with an AD/AS and an IS/LM graph. Discuss how either monetary or fiscal policy may be used to eliminate the recessionary gap. Be certain to discuss the process by which the gap us eliminated. Illustrate your answer with Ad/AD and IS/LM graphs. Discuss at least one factor that will determine the effectiveness of your policy as a counter-cyclical tool.

The current situation in the United States economy is one in which the aggregate demand (AD) curve has shifted to the left (refer to Graph 1) which moved the intersection of the AD1 curve from Point A (the intersection of the long run aggregate supply [LRAS] curve and the short run aggregate supply [SRAS]) to Point B (the intersection of the AD2 curve and the SRAS curve. The resulting recessionary gap is the difference in output reflected by the distance between Y1 (output at full employment) and Y2 (output at recessionary levels).